22/01/2021 1 • Net Present Value (NPV)/ Internal Rate of Return (IRR) Recap: Business valuation , WACC, capital Structure & NPV Net present value (NPV): the sum of the present values of all cash inflows minus the sum of the present values of all cash outflows. The internal rate of return (IRR): (1) the discount rate that equates the sum of the present values of all cash inflows to the sum of the present values of all cash outflows; (2) the discount rate that sets the net present value equal to zero. The internal rate of return measures the investment yield. PGDBFS 202-FSG 1 You are looking at a new project and have estimated the following cash flows: Year 0: CF = -165,000 Year 1: CF = 63,120 Year 2: CF = 70,800 Year 3: CF = 91,080 Your required return for assets of this risk is 12%. Determine the NPV of the Project PGDBFS 202-FSG 2 1 2
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• Net Present Value (NPV)/
Internal Rate of Return (IRR)
Recap: Business valuation , WACC, capital
Structure & NPV
Net present value (NPV): the sum of the present values of all
cash inflows minus the sum of the present values of all
cash outflows.
The internal rate of return (IRR): (1) the discount rate that
equates the sum of the present values of all cash inflows
to the sum of the present values of all cash outflows;
(2) the discount rate that sets the net present value
equal to zero.
The internal rate of return measures the investment yield.
PGDBFS 202-FSG 1
You are looking at a new project and have estimated the
following cash flows:
Year 0: CF = -165,000
Year 1: CF = 63,120
Year 2: CF = 70,800
Year 3: CF = 91,080
Your required return for assets of this risk is 12%. Determine the
NPV of the Project
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Annuity
• An annuity is a series of periodic payments that are
received at a future date.
• The most common payment frequencies are yearly,
semi-annually (twice a year), quarterly and monthly.
There are two basic types of annuities: ordinary
annuities and annuities due.
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Future Value Of An Annuity
• The future value of an annuity is the value of a group of recurring
payments at a specified date in the future; these regularly recurring
payments are known as an annuity. The future value of an annuity
measures how much you would have in the future given a specified
rate of return or discount rate.
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Present Value Of An Annuity
• The present value of an annuity is the current value of a set ofcash flows in the future, given a specified rate of return ordiscount rate. The future cash flows of the annuity arediscounted at the discount rate. Thus, the higher the discountrate, the lower the present value of the annuity.
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Perpetuities
• A perpetuity is a constant stream of identical cash flows
with no end. The formula for determining the present
value of a perpetuity is as follows:
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The Present Value of a Growing Perpetuity
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In growing perpetuities, the periodic cash flows grow at a constant rate
each period.
The present value of a growing perpetuity can be calculated using a
simple mathematical equation:
• Internal Rate of Return (IRR)
– IRR is simply the discount rate at which the NPV of the project
equals zero.
– You can calculate the rate of return on a project by:
1. Setting the NPV of the project to zero.
2. Solving for “r”.
– Unless you have a financial calculator, this calculation must be
done by using trial and error!
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Cost of Capital & WACC
• Cost of capital components
– Debt
– Preferred stock
– Common equity
• Application
✓ Min Req’d return needed on Project
✓ Reflects blended costs of raising capital
✓ Relevant “i ”
✓ Discount rate used to determine Project’s NPV or
to
✓ Hurdle rate
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Weighted Average Cost of Capital (WACC)
• WACC: Blended cost or raising capital considering mix of
debt & equity
• WACC = (Wt of Debt)(After-tax cost of Debt) + Wt of
Eqty)(Cost of Eqty) + (Wt of Prfd)(Cost of Prfd)
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Recap: Business valuation , WACC, capital
Structure & NPV
• Business Valuation
• Why?
– Quoted companies- Merger or takeover bid( determine the fair offer price
– Unquoted companies
• The company wish to go public
• Merger
• To sold
- Other: When there is MBO
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Valuation of listed companies
• Market Capitalization
– market value of a company's outstanding shares.
– Generally current market price is used for base figure
Valuation of listed companies
• Does not have stock market price
• Determining the value is difficult
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Different valuation techniques
• Asset Valuation bases
• Earning valuation basis– P/E ratio method of valuation
– The earning yield valuation method
– ARR method
– Dividend valuation basis
• Cash Flow valuation basis
– Discounted future cash flow basis
– Free cash flow method
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Cash Flow valuation basis
Free Cash Flow Valuation
• Free cash flow valuation is an approach to business valuation in which the businessvalue equals the present value of its free cash flow. It involves projecting free cashflows into future and then discounting them at the appropriate cost of capital.
Formula
• The most basic free cash flow valuation models are similar to the dividend discountmodel. The following formulas are using to calculate business value and businessequity value respectively:
Total Business Value (under FCFF model) = FCFF Next Year
WACC − g
Equity Value Under FCFF Valuation Model = Total Business Value − Market Value of Debt
Business Equity Value (under FCFE model) = FCFE Next Year
r − g
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• Operating free cash flow = Revenues
-operating cost
+ Deprecation
- Debt payments
- Working capital increase/+ WIC decrease
- Taxes
- Capital expenditure
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Asset Valuation bases
• Asset base is mostly used to determine minimum value
which can be useful for business is difficult to sell.
• Basis: Value per share : Net tangible assets*
No of shares
* Intangible assets should be excluded unless it
has mkt value
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• Ex: Summary of the statement of financial position of A company are as follows
• No of shares 100,000 & determine the value of the company
Non current asset Rs,000
PPE 150,000
Good Will 50,000
Current asset
Inventory 60,000
Trade Receivables 20,000
Cash 8,000
Ordinary shares 120,000
Reserves 30,000
Preference shares 50,000
Debentures 40,000
Current liabilities
Payables 22,000
Dividend payables 16,000
Tax payable 10,000
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Earning valuation basis
• P/E ratio method
• Price-Earnings Ratio - P/E Ratio
The price-earnings ratio (P/E ratio) is the ratio for valuing a companythat measures its current share price relative to its per-shareearnings. The price-earnings ratio is also sometimes known asthe price multiple or the earnings multiple.
The price-earnings ratio indicates the rupee amount an investor can expect to invest in a company in order to receive one rupee of that company’s earnings. This is why the P/E is sometimes referred to as the multiple because it shows how much investors are willing to pay per Rupee of earnings
• PE ratio relates earning per share to shares value
PE Ratio = MPS
EPS
Then
MPS= EPS x PE ratio
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Earnings yield valuation (EY)
EY = EPS x 100
MPS
Then’ MPS= Earning/ EY
Accounting rate of return (ARR) method
Value= Estimate future profit
Required return on capital
i.e
“A” company expected to acquire “ B” Company, avg earnings 100Mn. HWafter acquisition , “ A” company expect that “ B “ company earnings willincrease to 150Mn. Also they expect 10% of capital employed. Determinethe “ B” company value
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Dividend Valuation basis
• The Dividend Discount Model (DDM) is a method to estimate the
value of a share of stock by discounting all expected future dividend
payments. The basic DDM equation is:
• In the DDM equation:
– P0 = the present value of all future dividends
– Dt = the dividend to be paid t years from now
– k = the appropriate risk-adjusted discount ratei.eSuppose that a stock will pay three annual dividends of Rs. 200 per year, and
the appropriate risk-adjusted discount rate, k, is 8%.
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The Dividend Discount Model:
the Constant Perpetual Growth Model
• Assuming that the dividends will grow forever at a constant growth rate g.
• For constant perpetual dividend growth, the DDM formula becomes:
( )k)g :(Important
gk
D
gk
g1DP 10
0 −
=−
+=
In 2017, the dividend paid by the utility company, ABC PLC, was Rs 2.12.
Required rate of return of ABC share holders is 10% . & expect earning
will grow at 3% . Determine the value of stock
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Ratio) Payout - (1 ROE
Ratio Retention ROE Rate Growth eSustainabl
=
=
Return on Equity (ROE) = Net Income / Equity
Payout Ratio = Proportion of earnings paid out as dividends
Retention Ratio = Proportion of earnings retained for investment
The Sustainable Growth Rate
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Shareholder value Analysis
• Value creation using NPV approach
• Shareholder value is the total return to shareholders in
terms of both dividend & capital gain , calculated as
present value of future free cash flows of the entity
discounted at the WACC of the entity less market value
of debt
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The Two-Stage Dividend Growth Model
• The two-stage dividend growth model assumes that a firm will initially grow
at a rate g1 for T years, and thereafter grow at a rate g2 < k during a
perpetual second stage of growth.
• The Two-Stage Dividend Growth Model formula is:
2
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T
1
T
1
1
10
gk
)g(1D
k1
g1
k1
g11
gk
)g(1DP
−
+
+
++
+
+−
−
+=0
i.e. ABC Plc ., has been growing at a phenomenal rate of 20% per year. You
believe that this rate will last for only three more years. Then, you think the rate
will drop to 10% per year. Total dividends just paid were 5 million.
